Question

Draw a graph representing a loanable funds market. Assume inelastic supply of loanable funds. Make

sure to label axes, curves, and equilibrium. Write down equations for each of the curves.

b) Interpret the slope of the demand for loanable funds curve.

c) Interpret the slope of the supply of loanable funds curve.

In 2020, the COVID pandemic has spread around the world. Some substantial policy changes in response

to the adverse effects of the pandemic in the US included an increase in spending on publicly provided

medical tests and provision of stimulus checks to public ($1200 per person).

d) Focus on these two events only and illustrate them on your loanable funds model diagram.

e) What changes to the equilibrium can you predict with this model going from (a) to (d) and what is the intuition for your prediction?

Answer 1

SOLUTION:

PART (a), (b) and (c)

The question in itself is a great practical example of what might be the effects of governments spending on the economy.

Let us assume that we have a closed economy model, so we can write out Savings Function as the difference between the Total Income, and The Total Expenditure (Consumption and Government Expenditure).

So we have, S = Y - C - G = S = Y - [C_o + c(Y-T)] - G; where in the Loanable Funds Market we can write that the slope of this curve is 0 if we have an Inelastic curve as assumed according to the question.

Equation of Savings curve (Supply of Loanable Funds); S = Y - [C_o + c(Y-T)] - G

Slope of Savings curve (Supply of Loanable Funds) = 0 ; as changes in Interest will have no change in Savings as savings (supply of loanable funds) is Inelastic.

(If the savings is Non-Elastic, we have S = S(r); where S'(r) > 0, i.e change in interest has a positive change in Savings)

Similarly, we can write the equation of the Demand for Loanable Funds (Investment).

We know that Investment is Inversely related to Interest rate, in a way that when Interest rises, Firms usually reduce their investment due to higher interest payments.

So we can write,

Equation of Investment curve (Demand of Loanable Funds); I = I(r); where I'(r) < 0

Slope of Investment curve (Demand of Loanable Funds) = I'(r) < 0

Thus, we can plot the function on a graph as shown below. Also, the Equilibrium is indicated, where we get the Equilibrium Quantity of Funds and the Equilibrium Interest Rate as shown.

PART (d) and (e)

Now, we can interpret the next part of the Answer using some intuition and a graphical analysis.

The situation given basically indicates the government spending in huge amounts to ensure the public safety in the covid pandemic. They do so by issuing checks and public testing to ensure that people can purchase their necessities, stay safe and thus, the government is attempting to ensure social security. However, we clearly understand that this can have adverse effects on the economy and the market for Loanable Funds.

The situation basically indicates that there is an increase in the Government Expenditure, i.e. G rises.

We can clearly make an interpretation from the previous sentence. If we see the equation of the Supply of Loanable funds (Savings Function), we see that there is a 'G' term in it.

So, we have S = Y - [C_o + c(Y-T)] - G, where if G increases, S will FALL, as G has a 'Negative' term attached to it.

Now, this is known as an exogenous shock to the market for loanable funds. Changes in interest do not cause any changes, however external factors such as G may create disequilibrium in the market.

Thus, as G increases, S will FALL, the Inelastic Savings curve (Supply of Loanable Funds) will move backwards.

Consider the diagram below.

Thus, when the G rises, savings fall leading to fall in the Equilibrium Quantity of Loanable Funds, and a rise in the Equilibrium Interest Rate.

Now, this rising interest can have even other effects on the economy. One possible effect can be the falling Investment in the short run which is very much evident from the unstable Stock market which is prevailing at the moment.

Now, this directly points us to one particularly interesting phenomenon, which we know as the Crowding Out Effect.

The situation basically indicates that when the government spends more, G rises, leading to rising interest rates.

However, we must understand the intuition behind this phenomenon. If we consider an IS-LM analysis to this situation, we can say, that when G increases, the IS curve will shift upward, just like the Savings curve moved backwards.

Both these movements have one effect in common. Both lead to a rise in the Interest Rate. Interest rate rising basically has one particular effect; FALLING INVESTMENT as Investors do not want to pay higher Interest from the investments they make.

Thus, Higher Government Expenditure can lead to Crowding out of the Investment in the economy.